Chapter 14

Decision Making:
Relevant Costs and
Benefits

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 14-1 – Describe seven
steps in the decision-making process and the
managerial accountant’s role in that process.

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 The Managerial Accountant’s Role
in Decision Making

Managerial
Accountant
Cross-functional
management teams
Designs and implements who make
accounting information production, marketing,
system and finance decisions

Make substantive
economic decisions
affecting operations
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 The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Quantitative 4. Develop a Decision Model

Analysis
5. Collect the Data

6. Select an alternative

7. Evaluate decision

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Learning Objective 14-2 – Explain the
relationship between quantitative and qualitative
analyses in decision making.

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 The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the
responsibility of the 3. Identify the Alternatives
managerial
accountant. 4. Develop a Decision Model

5. Collect the Data

Information should be:
1. Relevant 6. Select an alternative
2. Accurate
3. Timely 7. Evaluate decision
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 The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Qualitative
Considerations 4. Develop a Decision Model

5. Collect the Data

6. Select an alternative

7. Evaluate decision
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 The Decision-Making Process
1. Clarify the Decision Problem
Relevant
Pertinent to a
decision problem. 2. Specify the Criterion

Accurate 3. Identify the Alternatives

Information must
be precise. 4. Develop a Decision Model

5. Collect the Data

Timely
Available in time 6. Select an alternative
for a decision
7. Evaluate decision
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Learning Objective 3 – List and explain two
criteria that must be satisfied by relevant
information.

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 Relevant Information

Information is relevant to a decision

problem when . . .
1. It has a bearing on the future,
2. It differs among competing alternatives.

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Learning Objective 14-4 – Identify relevant
costs and benefits, giving proper treatment to
sunk costs, opportunity costs, and unit costs.

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 Identifying Relevant
Costs and Benefits

Sunk costs
Costs that have already been incurred. They do
not affect any future cost and cannot be changed
by any current or future action.

Sunk costs are irrelevant to decisions.

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 Relevant Costs
Worldwide Airways is thinking about replacing a three
year old loader with a new, more efficient loader.
New loader
List price $ 15,000
Annual operating expenses 45,000
Expected life in years 1
Old loader
Original cost $ 100,000
Remaining book value 25,000
Disposal value now 5,000
Annual variable expenses 80,000
Remaining life in years 1
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 Relevant Costs
If we keep the old loader, we will have depreciation
costs of $25,000. If we replace the old loader,
we will write-off the $25,000 when sold. There is
no difference in the cost, so it is not relevant.

We will only have depreciation on the new loader

if we replace the old loader. This cost is relevant.

The $5,000 proceeds will only be realized if we

replace the old loader. This amount is relevant.

The new loader will be depreciated in one year.

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 Relevant Costs
Keep Old Replace Old Differential
Loader Loader Cost
Depreciation of old loader $ 25,000
Write-off of old loader $ 25,000 $ -
Proceeds from sale of old loader (5,000) 5,000
Depreciation of new loader 15,000 (15,000)
Operating costs 80,000 45,000 35,000
Total costs $ 105,000 $ 80,000 $ 25,000

The difference in operating costs is relevant

to the immediate decision.

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 Relevant Costs
Here is an analysis that includes only
relevant costs:
Relevant Cost Analysis
Savings in variable expenses
provided by the new loader $ 35,000
Cost of the new loader (15,000)
Disposal value of old loader 5,000
Net effect $ 25,000
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 Opportunity Costs
 The potential benefit given up when the
choice of one action precludes a different
action.
 People tend to overlook or underestimate
the importance of opportunity costs.
Learning Objective 14-5 – Prepare
analyses of various special decisions, properly
identifying the relevant costs and benefits.

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 Analysis of Special Decisions
Let’s take a close look at some special decisions
faced by many businesses.
We just received
a special order. Do
you think we should
accept it?

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 Accept or Reject a Special Order
 A travel agency offers Worldwide Airways $150,000
for a round-trip flight from Hawaii to Japan on a
jumbo jet.
 Worldwide usually gets $250,000 in revenue from
this flight.
 The airline is not currently planning to add any
new routes and has two planes that are idle and
could be used to meet the needs of the agency.
 The next screen shows cost data developed by
managerial accountants at Worldwide.

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 Accept or Reject a Special Order
Typical Flight Between Japan and Hawaii
Revenue:
Passenger $ 250,000
Cargo 30,000
Total $ 280,000
Expenses:
Variable expenses 90,000
Allocated fixed expenses 100,000
Total 190,000
Profit $ 90,000

Worldwide will save $5,000 in reservation

and ticketing costs if the charter is accepted.
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 Accept or Reject a Special Order
Assumes excess capacity
Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Contribution from charter $ 65,000

Since the charter will contribute to fixed costs and

Worldwide has idle capacity, the company should
accept the flight.

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Accept or Reject a Special Order

What if Worldwide had no excess capacity? If

Worldwide adds the charter, it will have to cut
its least profitable route that currently
contributes $80,000 to fixed costs
and profits. Should Worldwide still accept
the charter?

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Accept or Reject a Special Order
Assumes no excess capacity
Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Opportunity cost:
Lost contribution on route 80,000 165,000
Total $ (15,000)

Worldwide has no excess capacity, so it

should reject the special charter.
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 Accept or Reject a Special Order
With excess capacity . . .
 Relevant costs will usually be the variable costs
associated with the special order.

Without excess capacity . . .

 Same as above but opportunity cost of using the
firm’s facilities for the special order are also relevant.
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 Outsource a Product or Service
A decision concerning whether an item should be
produced internally or purchased from an outside
supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the management

of Worldwide Airways.

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 Outsource a Product or Service
 An Atlanta bakery has offered to supply the in-
flight desserts for 21¢ each.
 Here are Worldwide’s current cost for desserts:

Variable costs:
Direct material $ 0.06
Direct labor 0.04
Variable overhead 0.04
Fixed costs:
Supervisory salaries 0.04
Depreciation of equipment 0.07
Total cost per dessert $ 0.25
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 Outsource a Product or Service
Not all of the allocated fixed costs will be saved
if Worldwide purchases from the outside bakery.
Cost per Savings from
Dessert Outsourcing
Variable costs:
Direct material $ 0.06 $ 0.06
Direct labor 0.04 0.04
Variable overhead 0.04 0.04
Fixed costs:
Supervisory salaries 0.04 0.01
Equipment depreciation 0.07 -
Total cost per dessert $ 0.25 $ 0.15
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Outsource a Product or Service
If Worldwide purchases the dessert for 21¢, it
will only save 15¢ so Worldwide will have a
loss of 6¢ per dessert purchased.

Wow, that’s
no deal!

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 Add or Drop a Service,
Product, or Department

One of the most important

decisions managers make is
whether to add or drop a
product, service, or
department.

Let’s look at how the concept of

relevant costs should be used in
such a decision.
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 Add or Drop a Product
Worldwide Airways offers its passengers
the opportunity to join its World
Express Club. Club membership entitles
a traveler to use the club facilities at the
airport in Atlanta.
Club privileges include a private lounge
and restaurant, discounts on meals and
beverages, and use of a small health spa.

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 Add or Drop a Product
Sales $200,000
Less: Variable Costs:
Food/Beverage $70,000
Personnel 40,000
Variable overhead 25,000 (135,000)
Contribution Margin 65,000
Less: Fixed Costs:
Depreciation $30,000
Supervisor salary 20,000
Insurance 10,000
Airport fees 5,000
Allocated overhead 10,000 ( 75,000)
Loss $ ( 10,000)
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 Add or Drop a Product
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Depreciation (30,000) (30,000) 0
Supervisor salary (20,000) 0 (20,000)
Insurance (10,000) (10,000) 0
Airport fees ( 5,000) 0 ( 5,000)
Allocated overhead (10,000) (10,000) 0
Loss $ (10,000) $(50,000) $ 40,000

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 Add or Drop a Product
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000
N 0 A $200,000
Food/Beverage O
(70,000) 0 V (70,000)
Personnel T
(40,000) 0 (40,000)
O
Variable overhead (25,000) 0 I (25,000)
A
Contribution Margin 65,000
V 0 65,000
D
Depreciation (30,000)
O (30,000) 0
Supervisor salary (20,000) 0 A (20,000)
I
Insurance D
(10,000) (10,000) B 0
Airport fees A
( 5,000) 0 L ( 5,000)
B
Allocated overhead (10,000) (10,000) E 0
L
Loss (10,000)
E (50,000) 40,000
The positive $40,000 differential amount reflects the fact that the
company is $40,000 better off by keeping the club.
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 Add or Drop a Product
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Avoidable fixed costs
Supervisor salary (20,000) 0 (20,000)
Airport fees ( 5,000) 0 ( 5,000)
Profit/Loss $ 40,000 $ 40,000

Worldwide airlines would also lose the contribution

margin of $65,000. The club contributes $40,000 to
Worldwide’s fixed costs.
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 Conclusion
KEEP THE CLUB OPEN!

Contribution margin from

general airline operations
that will be forgone if club
is eliminated . . . . . . . . . . . $ 60,000 –0– $ 60,000
Profit/Loss $ 40,000 –0– $ 40,000
Monthly profit of
KEEPING the club open $100,000
The Opportunity Cost of =======
lost contribution margin is Worldwide is better off by
$60,000. $100,000 per month by
keeping its club open.
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End of Chapter 14

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